A federal appeals court yesterday threw out a controversial rule that sought to tighten oversight of the $1.2 trillion hedge fund industry, casting grave doubt on the government's power to regulate the fast-growing investment pools.

The U.S. Court of Appeals for the D.C. Circuit cited what it called an "arbitrary" rationale that the Securities and Exchange Commission employed to adopt the rule over fierce opposition two years ago. The rule prompted nearly 1,300 advisers each with more than 14 clients and at least $25 million under management to turn over information and open their books to SEC inspection.

The court ruling came on the same day as disclosures that federal securities regulators are investigating Pequot Capital Management Inc., a $7 billion hedge fund, for possible insider trading, according to the fund and sources familiar with the government's probe. The investigation was reported Friday by the New York Times.

"At all times, Pequot's securities trading has been entirely proper and not based on insider information," Jonathan Gasthalter, a spokesman for the fund, said in a prepared statement. "The trades at issue were made in the ordinary course of the firm's business and were entirely normal within the context of its daily investing activities."

Once the exclusive province of the wealthy, hedge funds increasingly have attracted interest from average investors and public-pension holders for their outsize returns and eye-popping compensation practices. Investigations by state and federal authorities have uncovered evidence of trading violations and other wrongdoing at nearly 80 funds, according to SEC statistics. While hedge funds represent a small fraction of the nation's total investment, they are responsible for heavy trading volumes. Risky bets by high-profile Long Term Capital Management forced regulators to help negotiate a private-sector $3.6 billion bailout in 1998, in what remains the signature example of the dangers of hedge funds.

"That the Commission wanted a hook on which to hang more comprehensive regulation of hedge funds may be understandable," U.S. Appeals Court Judge A. Raymond Randolph wrote in yesterday's unanimous ruling. "But the Commission may not accomplish its objective by a manipulation of meaning."

The three-judge panel criticized securities regulators for too broadly interpreting legal definitions as a way to bring hedge funds under their scrutiny. The court said the SEC had improperly counted each fund investor as a client in an effort to make many more advisers subject to oversight. In doing so, the SEC was "painting with such a broad brush" that the agency misinterpreted the Investment Advisers Act of 1940, the panel said.

The plan, adopted by the SEC in December 2004 after a 3 to 2 vote, also was divisive within the Bush administration. Federal Reserve Board Chairman Alan Greenspan and Treasury Secretary John W. Snow, among others, voiced opposition on the grounds that it could stifle entrepreneurship and that it wasted the agency's limited resources. But SEC Chairman William H. Donaldson supported the rule and moved it forward.

"We just plowed through on our own," said Commissioner Paul S. Atkins, a critic of the plan.

The SEC's current chairman, Christopher Cox, said in a prepared statement yesterday that the court decision would push the SEC to "reevaluate the agency's approach to hedge fund activity." Cox said he would consult with other members of the President's Working Group on Financial Markets, many of whom had previously expressed concern about the hedge fund provision.

Philip D. Bartz, a lawyer at McKenna Long & Aldridge LLP who represented New York hedge fund adviser Phillip Goldstein in challenging the rule, said the agency has minimal "wiggle room" to tinker with the regulation, a conclusion with which lawyers not involved in the case agreed.

The appeals court doesn't "absolutely preclude" the SEC from reviving the rule, "but it won't be easy," said former agency general counsel David M. Becker, now a partner at Cleary Gottlieb Steen & Hamilton LLP in Washington. "The court now insists on a much more closely reasoned explanation for SEC actions and doesn't defer very much to the agency's expertise."

The hedge fund decision marks the third time in less than a year that the appeals court has rebuffed the agency, pointed out David Hirschmann, a senior vice president at the U.S. Chamber of Commerce, which has accused the SEC of acting beyond its authority. Twice previously, the court sent back to the agency for more analysis a rule requiring mutual fund board chairmen to be independent of management.

More than 1,200 new funds, out of estimates that range as high as 13,800, have registered since January 2005 with the SEC and agreed to maintain records and open their books for inspection pursuant to the rule. Advisers that invest on behalf of public pension plans and charities voluntarily register with the government, a status unchanged by the court decision.

John G. Gaine, president of the Managed Funds Association, an industry trade group, said funds that had submitted information to the agency pursuant to the rule probably would have to take the affirmative step of withdrawing their paperwork. SEC officials will continue to examine the operations of funds that are registered, which could become a selling point for investors.

Former SEC member Harvey J. Goldschmid, who voted to approve the plan, yesterday urged regulators to appeal to the U.S. Supreme Court, members of Congress, or both. In the Pequot case, a former SEC lawyer who worked on the Pequot investigation before being fired by the agency has written a letter to key members of the Senate banking and finance committees alleging that the SEC dropped the probe because of political pressure from the hedge fund and top Wall Street investment banks that he alleges profited from the fund's trading activities. The fund is run by Arthur Samberg.

Gary J. Aguirre, fired by the SEC last August, said in the letter that his bosses at the SEC prevented him from interviewing a top Wall Street executive with ties to the Bush administration about the alleged illegal trading. The SEC officials denied Aguirre's request to interview the executive because of political pressure, he wrote. Sources close to the matter who spoke on condition of anonymity because they aren't supposed to discuss the situation publicly said the official was John J. Mack, who was chairman of Pequot and is now chief executive of Morgan Stanley.

Aguirre said his supervisor at the SEC initially backed his request to question Mack but later told Aguirre to back down, citing Mack's "powerful political connections."

Aguirre also said in his letter that insider trading is widespread among hedge funds.

SEC officials yesterday would not comment on Aguirre, saying they do not discuss personnel matters. However, sources familiar with the situation, who spoke on the condition that they not be identified because of the ongoing investigation, said the SEC has not dropped the probe. They said Aguirre's request to interview Mack was denied because his supervisors thought he didn't have evidence linking Mack to potential wrongdoing. In his letter to senators, Aguirre said that he had such evidence.

The SEC's inspector general, in a report to Congress in April, said his office had reviewed Aguirre's claims and "failed to substantiate the allegations."

Aguirre's lawyer, Joanne Royce, was unavailable for comment yesterday. Royce is a staff attorney at the Government Accountability Project, a nonprofit group that specializes in helping government workers who say they were fired for trying to alert their superiors about wrongdoing. A statement from the group said Aguirre would not comment.

After receiving Aguirre's letter, staff members of the Senate Banking Committee and the Senate Finance Committee requested and received a briefing from SEC officials about the investigation. Sources familiar with the briefings said that senators on both committees continue to "actively" investigate Aguirre's accusations.

Morgan Stanley spokesman James Badenhausen issued a statement on behalf of the firm and Mack: "Mr. Mack has never been contacted on this matter by the SEC, and we have no reason to believe that the SEC has any interest in Mr. Mack in connection with this matter."